When is it a good idea to borrow money, and when should you avoid debt? Learn how loans and interest rates work so you know when it is worthwhile to borrow and how to pay down debts.
Is debt always bad?
Debt, money that is borrowed, might seem like something that you would want to avoid. However, debt isn’t always bad. It can be useful for helping you reach your financial goals.
For example, taking out student loans to earn a degree often leads you to a higher-paying job after you graduate and borrowing money to buy property could benefit you in the long-term if the property you buy appreciates.
Still, debt comes with hefty costs because each time you borrow, you must pay interest to your lender, money on top of the original amount you borrowed, and that interest can increase significantly over time.
Furthermore, if you fall behind on payments or take out too much debt, it can negatively impact your credit worthiness, which will prevent you from being able to borrow as much money in the future and can lead you to pay higher interest rates on new loans.
Interest rates
Usually when you borrow money, you agree to pay the lender interest, extra money on top of the amount you are borrowing, at a certain rate. The interest you pay to the lender compensates them for the risk of lending you money. The riskier it is to lend you money, the higher your interest rate will be.
Your interest rate is a certain percentage of your principal, the original amount you borrowed. For example, Casey borrows $2000 at an annual percentage rate (APR) of 5%. At the end of the year, if she has not made any payments, she would owe the borrower the principal, $2000 plus $100 of interest.
Credit cards and personal loans usually have the highest interest rates because they are money you borrow without collateral, an asset that can be taken if you can’t make your loan payments. Other types of debt such as mortgages and car loans, often have lower interest rates, but the interest rate that you are charged depends on your own financial situation and the overall economic situation.
Compound interest
Most interest on loans is compound interest, meaning that the interest at the end of a given period is added to the principal when calculating how much more interest you need to pay.
For example, if you borrow $2000 at an annual percentage rate of 5%, you will owe $100 dollars in interest plus the $2000 principal at the end of one year if you have not made any payments.
Then after 2 years, if you still have not made any payments and your interest compounds annually, you will owe 5% of $2100 plus the principal, so $2205. After 10 years, if you still have not made payments, you will owe a total of $3,257.79.
Compound interest causes debt to grow exponentially, leading to you accumulating more debt. This means that debt can spiral out of control if you do not take steps to address it.
Types of interest rates
A fixed interest rate means that you will accumulate interest at the same percentage rate each period. A variable interest rate changes over time. Variable interest rates may be useful if you can pay off your debt before the interest rate changes or if the interest rate decreases. However, if the interest rate increases, you could have a harder time paying off your debt.
For example, Casey is deciding between a fixed rate loan and a variable rate when she is buying a house. If she takes out a fixed rate loan, she will have the same monthly payment for the whole loan.
If she takes an adjustable-rate mortgage (ARM) that has an interest rate that changes after 5 years, she will start out with a smaller payment, but it might increase after 5 years, causing her to not be able to afford her mortgage payments. She decides to take out the fixed rate loan even though it is more expensive in the short-term because she wants to make sure she will be able to afford her future payments.
What is amortization?
Amortization is a way of paying back a loan with interest on a fixed schedule so that the percentage of the principal that you pay increases over time, while the percentage of interest decreases. This type of payment schedule is used with fixed rate mortgages and other types of loans.
When you take out a loan with an amortization schedule, you agree to pay back a loan over a set period, such as 10 years or 30 years. Your lender calculates the total amount of principal and interest you will pay over the life of the loan based on your interest rate, and then divides that amount into equal monthly payments.
However, when you first start to make the payments, you pay more interest than you do later. If you make regular payments, at the end of the period, your loan will be paid off.
Paying down debt
If you are already in debt, one of your goals may be to pay down your debt, meaning that you will contribute more than your required monthly payments to eliminate the debt more quickly.
It is important to consider the loan principal, the interest rate, and the type of loan when deciding which loans to prioritize.
The loans that have the highest interest rates should be your priority, such as credit cards, and personal loans, or any loans with a 10% interest rate or higher. If you have a loan with a lower interest rate but a higher principal, it still could be important to pay them down so your debt does not continue to increase.
If you are not sure which loan to prioritize, you can use loan calculators to determine which loans will cost you the most in the long run if you leave them untouched.
Avoiding bad debt
The best way to avoid debt that will harm your financial situation is to do your best to not spend more than you earn and to build emergency savings so that in the case of a financial emergency, you can dip into your savings instead of taking out loans.
Paying off credit card balances at the end of each month prevents you from having to pay interest. If it’s not possible to avoid taking out loans, finding a loan with a lower interest rate can keep your monthly payments affordable.
For example, if you are in school and need money to pay for your living costs, it is better to take out a student loan at a lower interest rate if possible than to charge your living costs on a credit card with a higher interest rate.
Creditworthiness
Creditworthiness refers to how likely someone is to pay back a loan. Each country has its own system for determining credit worthiness. Some countries, like the U.S., UK, and Canada, require lenders to report payments to credit bureaus who collect all the information and turn it into a credit score. Other countries, like the France and Japan, do not have a centralized system.
Factors that influence creditworthiness include the percentage of your total credit that you use on a regular basis, how long you have had a credit account open, and whether you make regular on-time payments. If you have a higher credit score, you are more likely to be approved for a loan in the future and you also may be given a lower interest rate.
Short-term costs of paying down debt
In the short-term, paying off a loan or closing a credit account could negatively impact your credit worthiness. This is because credit scores take into account how long your line of credit is. The longer you have been reliably paying off your debts, the better.
In that case, it might make sense to wait on fully paying off your oldest loan until after you secure a new loan.
When Casey finishes paying off her credit card balance, she considers throwing away her credit card entirely so she is not tempted to charge more on it than she can afford.
However, she realizes that her credit card is her oldest line of credit, so closing it would decrease her credit score. She decides to keep it open but to pay off her balance in full each month.
Long-term costs of paying down debt
Paying off your debt more quickly than the required monthly payments usually means you pay less interest. However, if you have a low interest rate, the opportunity cost of paying down your debt might be high.
Opportunity cost is the amount your money could grow if you invested it. For example, if you took out a loan with a 2% interest rate with affordable monthly payments, and you could earn 7% on your money in the stock market, you would gain more money in the long term from investing your extra income instead of using it to pay off debt more quickly.
Since Casey’s student loans have an interest rate of 4% and she can afford the monthly payments, it would be smart for her to invest any extra money she saves into her retirement account, where it will earn a higher percentage return instead of paying back her loans more quickly.
Bankruptcy
If you cannot pay the debts you owe, you may be able to consolidate your debt for a lower interest rate or negotiate with your creditors to lower your monthly payments. In the worst-case scenario, you may have to declare bankruptcy, which means that you cannot repay your debts.
Each country has its own laws for determining how bankruptcy works, but usually bankruptcy requires you to sell all of your remaining assets to pay off debts. Some of your debts may be forgiven, and others you may have to pay following a strict plan determined by a court. Bankruptcy makes it very challenging to borrow money in the future.
